How does Venture Capital operate?

Building cohesive strategies in an evolving industry

So far, we have covered what venture capital is trying to achieve and why it makes economic sense to do it. Those were interesting, but somewhat theoretical conversations. Now let’s start thinking about how all of this gets operationalized — specifically in the context of a venture capital fund.

Fund investing (beyond just venture capital) can be broken down in four key processes— sourcing, selection, management, and realization. We need to be able to identify relevant investment opportunities, pick the best ones, work with them as they grow, and finally sell our investment for (hopefully) a handsome profit. We can’t really get away from doing any of these things, or the model does not work. There are, of course, other aspects of investing that we still need to do, but we might get away with not putting too much effort into them — things like fundraising (if we have a very rich and somewhat foolish uncle who will keep bankrolling us) and reporting (if that same uncle does not really care about how individual investments are trending).

So, if we want to be investors at a fund, we have to execute all these processes on at least some basic level. Luckily there are many ways to approach them. Take sourcing, for example: we can make sure we see a lot of relevant opportunities by cold-calling companies, by having a network of friends who refer them to us, by engaging with earlier stage funds that want us to lead the next round for their portfolio companies, and many, many other ways.

If we want to be good investors, we should probably think about how we can be better than the rest in at least some of these processes — to find an edge that other investors might not have. Just as an extreme example in the case of sourcing, there are a few truly outstanding investment firms out there that have built a great pipeline of interesting opportunities by creating the companies from scratch themselves and recruiting a leadership team to run them. This, of course, requires some careful and laborious research to identify a promising white space, but it is a viable tactic.

Now, if we want to be great capital investors, we should start looking at a cohesive strategy between sourcing, selection, management, and realization. That is, we don’t just need to be good at what we do, but we need to make sure that by getting better at any one of these processes there is a carryover effect that strengthens the rest. The easiest way to crystalize this, at least for me, is to think about the type of “no-brainer” expenses that you would always approve for members of your investment firm. Here are a few examples that illustrate this:

Let us take a relatively easy (and somewhat common) example of defining our strategy as a focusing on social networks and connections. In that case we can count on our network (of entrepreneurs, service providers, investors) to be the primary source of investment opportunities. When we are out to make an investment decision, we can lean on the network to get social proof — we ourselves don’t need to be experts if we can ask the experts for an opinion. The way we engage with our portfolio can then also be heavily social and our value-add can be around sales and partnership introductions. Finally, finding the right time to realize the investment and getting a good price is made much easier by us knowing a broad range of potential buyers and having strong banking relationships that get us to a favorable exit. In this strategy it does help to be smart and hard-working, but the core objective is to be connected and well-liked. And, to that end, any investment that our firm makes in social events, networking, or brand building is well spent.

An alternative strategy (which is, again, not uncommon) is to focus on systems and process. We would dedicate ourselves to building a sourcing pipeline through casting a wide net, collecting as much data as possible, and sifting for the best opportunities. Our analytical ability would be key in investment selection (think really fancy excel models and competitor benchmarks), but that expertise would also help strengthen the systems and operations of our portfolio companies. Finally, when it comes down to maximizing our exit value, data-driven negotiation and carefully modeled deal structures should work in our favor. Again, it always pays to be charming and insightful, but it is analytical ability and hard work make this strategy pay off. So, if we can spend money to obtain additional data, build analytical skills, or develop process automation, we should probably do it.

These are, of course, illustrative examples, although I am sure you can recognize an investment firm or two that might fit these broad descriptions. There are likely many other cohesive strategies that are far more sophisticated and effective. But the point I would like to make is that the lack of clarity around a firm’s strategy can be highly detrimental. With so many interesting ways to go about each investment process, it is tempting to attempt different strategies in each, and give a try to whatever is in vogue right now (Tour buses! Scouts! Quantitative sourcing!), or do a little bit of everything. Eventually there are only so many resources (time and money) that an organization can spend, and the lack of cohesive strategy can result in our well-intentioned firm just spinning its wheels. So hard choices need to be made about what to focus on and what to purposefully ignore. It is ok to never go to happy hours, or to not know the deeper intricacies of biopharmaceutical research, or to only issue plain vanilla term sheets, if those things don’t play to our strengths*.

Finally, I have to acknowledge a bit of an inconsistency in the narrative so far, and a pet peeve of mine. The structure I have outlined above does subtly imply that investment is a one-directional process in which the venture capitalist plays the pivotal and decisive role. While this may be in line with popular culture (I would love to be an investor on Shark Tank!), it is incorrect. Many of the functions outlined above require the venture investor to be pitching his wares, rather than the other way around. This is self-evident in the case of fundraising (convincing our LPs to back us) and exit management (convincing potential acquirers that our portfolio company is worth the very high price they are about to pay). Sales is, however, also a core part of the “selection” process. Companies choose their investors just as much as investors choose their companies. That choice is partially based on what the investor is valuing the company at today, but mostly driven the picture of eventual great success that they describe. This might be somewhat less true in banker-led distressed buyouts than in minority VC investments, but a good relationship with the CEO can work miracles in both situations. It is a common trope that venture capital is a sales job, and I find it to be profoundly true. Success here is a mix of charm, smarts, hard work, and a lot of luck — applied behind a cohesive strategy.

* I have to give significant credit here to Prof. Frances Frei of Harvard Business School and her work on high-performing service organizations. Among the many things that I learned from her, one particular one that stuck is that in order to be great at something, you might first have to choose something to be bad at. I strongly recommend her book “Uncommon Service: How to Win”.